chapter 16. determinants of the money supply money multiplier factors that determine multiplier...

Chapter 16. Determinants of the Chapter 16. Determinants of the Money SupplyMoney Supply

Chapter 16. Determinants of the Chapter 16. Determinants of the Money SupplyMoney Supply

• Money multiplier

• Factors that determine multiplier & MS

• Applications: Great Depression

• Money multiplier

• Factors that determine multiplier & MS

• Applications: Great Depression

• given problems with simple money multiplier,

• construct better multiplier• cash holdings• excess reserves holdings

• based on M1 = C + D

• given problems with simple money multiplier,

• construct better multiplier• cash holdings• excess reserves holdings

• based on M1 = C + D

I. money multiplierI. money multiplierI. money multiplierI. money multiplier

• how $1 change in MB will affect MS:

M = m x MB• how $1 change in MB will affect MS:

M = m x MB

rD = required reserve ratio

c = ratio of currency to deposits

e = ratio of excess reserves to deposits

m =

rD + e + c

1 + c

exampleexampleexampleexamplerD = .10 C = $400 billion D = $800 billion

ER = $.8 billion or $800 million

= 2.5

$1 increase in MB, $2.5 increase in M

m =.10 + .001 + .5

1 + .5

II. Factors affecting m & MSII. Factors affecting m & MSII. Factors affecting m & MSII. Factors affecting m & MS

• changes in rD

• changes in c

• changes in e

• changes in MB

• changes in rD

• changes in c

• changes in e

• changes in MB

changes in rchanges in rDDchanges in rchanges in rDD

• higher reserve requirement• fewer excess reserves to lend• smaller amount of deposit creation

• higher reserve requirement• fewer excess reserves to lend• smaller amount of deposit creation

higherrD

smallermultiplier

exampleexampleexampleexample

• rD was .10

• suppose it rises to .20

• rD was .10

• suppose it rises to .20

m = 2.14

m =.20 + .001 + .5

1 + .5

changes in cchanges in cchanges in cchanges in c

• higher c• currency does not expand like deposits• smaller amount of deposit creation

• higher c• currency does not expand like deposits• smaller amount of deposit creation

higherc

smallermultiplier

exampleexampleexampleexample

• original example: c = .5

• suppose c = .8• original example: c = .5

• suppose c = .8

m =.10 + .001 + .8

= 2.001 + .8

changes in ER/Dchanges in ER/Dchanges in ER/Dchanges in ER/D

• higher e• banks hold more ER, lend less• smaller amount of deposit creation

• higher e• banks hold more ER, lend less• smaller amount of deposit creation

highere

smallermultiplier

exampleexampleexampleexample

• original example: e = .001

• suppose e = .005• original example: e = .001

• suppose e = .005

m =.10 + .005 + .5

= 2.481 + .5

what affects e?what affects e?what affects e?what affects e?

• as interest rates rise• opportunity cost of holding ER rise• (money could be lent out)

• as interest rates rise• opportunity cost of holding ER rise• (money could be lent out)

higheri

ERfall

• expected deposit outflows• must hold more ER

• expected deposit outflows• must hold more ER

Factors affecting MBFactors affecting MBFactors affecting MBFactors affecting MB

• MB = MBn + DL• MBn is nonborrowed MB

-- open market purchase will

increase MBn

-- open market sale will

decrease MBn• increase MBn will increase M

• MB = MBn + DL• MBn is nonborrowed MB

-- open market purchase will

increase MBn

-- open market sale will

decrease MBn• increase MBn will increase M

• DL is discount loans

-- increase as banks borrow from

the Fed

-- increase as spread between

market interest rate and discount

rate increases

• DL is discount loans

-- increase as banks borrow from

the Fed

-- increase as spread between

market interest rate and discount

rate increases

Great Depression 1930-33Great Depression 1930-33Great Depression 1930-33Great Depression 1930-33

• big contraction in M1

• big increases in c, e• depositors withdrew cash• banks increase ER due to increase

in deposit outflow

• big contraction in M1

• big increases in c, e• depositors withdrew cash• banks increase ER due to increase

in deposit outflow

• as c and e rise,• money multiplier declines• M1 declines by 25% from 1930-33

• as c and e rise,• money multiplier declines• M1 declines by 25% from 1930-33